OPEC Channels Adam Smith

Reports that OPEC and Russia are going to end their two-year agreement to limit oil production is an act of necessity and a simple manifestation of an Adam Smith economic truism. In Adam Smith’s 1776 Wealth of Nations, he wrote, “It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest”. The decisions to terminate the agreement reflects the reality that OPEC is not really a cartel. OPEC isn’t what it used to be and never was. The media and policy makers called it a cartel but in reality it has mostly been a price taker; not a price maker.

The 2016 Agreement to limit production was an implicit admission that Saudi Arabia’s attempt to maintain market share in the face of growing US production was a flop that sowed the seeds of its own demise. The fact that it appears to have worked for two years may be a reflection of technical constraints on cheating by other members as well as the collapse of Venezuela’s oil production.

OPEC leaders know that rising oil prices zre a strong incentive for US producers, especially shale producers to step up drilling to increase revenue by taking advantage of higher prices. They also know that when prices get past $70 per barrel, there are incentives to invest in new technology if it appears that prices will not soon retreat. In addition to Adam Smith’s economic principle is the economic reality that the cure for high prices is high prices. High prices bring about more supply and when supply exceeds demand, prices drop.

Perhaps more important, as prices recovered from the lows of $40 per barrel, the incentive for members to cheat grew stronger. Cheating on quotas has been a characteristic of OPEC members for decades. Although today, the number of members who can cheat is fewer than when OPEC represented over 50% of world output, the incentive remains strong for those that can.

Cheating aside, the real reason was put into clear perspective by a recent piece by the Wall Street Journal. “The fact that U.S. production call fill the gap left by OPEC’s sick men … means that continuing to curtain output will benefit American producers.